What is ‘alpha decay’ in finance, and are past returns indicative of future returns after all? originally appeared on Quora: the place to gain and share knowledge, empowering people to learn from others and better understand the world.
Answer by Julien Penasse, Associate Professor of Finance at University of Luxembourg, on Quora:
In finance, ‘alpha’ refers to the ability of a strategy to outperform the market, taking into account the level of risk involved. Simply put, if an investment approach consistently yields strong returns, it’s said to have ‘alpha’. Value investing is a prime example of such a strategy. This approach involves purchasing stocks that are priced lower relative to their earnings and selling short those with higher prices compared to their earnings. Historically, this method has been effective in delivering better-than-average returns.
Investing in the stock market carries significant risk, and the returns from long-short strategies are often volatile. Numerous strategies struggle to maintain strong returns over extended periods. This variability in performance can be attributed to chance or the inherent risks associated with these strategies. Additionally, the effectiveness of many strategies tends to diminish once they become widely known. A notable instance of this phenomenon is the ‘size effect’, first identified by Rolf Banz in 1981. This effect, which initially suggested that smaller firms outperformed larger ones, appeared to dissipate in the United States following the publication of Banz’s research.
Many widely-used investment strategies experience a similar decline in effectiveness, a phenomenon known as ‘alpha decay’. This term refers to the diminishing returns of strategies over time, particularly after they become public knowledge. Alpha decay appears to be a widespread issue in finance. A 2016 study conducted by David McLean and Jeffrey Pontiff revealed that on average, the returns from popular stock market strategies drop by 58% after their details are published.
That’s not necessarily surprising. In the world of finance, it’s prudent to approach claims of high risk-adjusted returns with skepticism. This is reflected in the commonly seen disclaimer, “past returns are not indicative of future returns.” Alpha decay can typically be traced back to two main reasons.
Reason one for alpha decay is “data snooping,” which suggests that the perceived alpha was never truly there. With the vast array of methods to manipulate data, it’s not surprising that some strategies appear to deliver alpha. Reason two is crowding. Initially profitable strategies can lose their edge as they become more widely known and adopted. As more investors employ the same strategy, its profitability diminishes. This is exemplified by the size effect; after many funds were established to capitalize on this phenomenon, it seemingly vanished, leading many to believe that its disappearance was due to the strategy becoming too crowded.
You might be tempted to believe that a strategy is genuine if it continues to work well immediately after becoming public knowledge. However, this is a mistaken assumption. In my research, I have shown that the impact of crowding can be deceptive. It’s possible for a strategy to remain highly profitable shortly after it becomes public and yet still succumb to decay later on. This phenomenon underscores the nuanced and often delayed effects of crowding in financial strategies.
Consider the following example: your investment strategy focuses on buying small stocks that are relatively cheap and shorting large stocks that are relatively expensive. Initially, this approach generates alpha. However, as other investors start adopting your strategy, they inadvertently affect the market dynamics. Their collective actions raise the prices of the small stocks you are investing in and lower the prices of the large stocks you are shorting. This leads to a temporary surge in returns for your strategy. This uptrend persists only until the market prices adjust, at which point the alpha generated by your strategy effectively vanishes.
The magnitude of this effect can be substantial. In my analysis, I propose that for a typical strategy, there is a three percent increase in returns for every one percent decline in alpha. This significant shift can lead to the erroneous conclusion that a strategy is profitable when, in reality, it is not. Take the size effect as an example: after Banz’s paper was published, returns remained notably high for approximately two years. This illustrates a critical lesson for investors: past returns might seem predictive of future performance, but this relationship can abruptly end. Caution is advised not only regarding data snooping but also in the case of ‘honeymoon returns’ following a strategy’s public release. These returns, often appearing exceptionally promising, may ultimately prove to be unsustainable.
For more in depth and technical details on this topic:
Julien Pénasse (2022) Understanding Alpha Decay. Management Science 68(5):3966-3973.
This question originally appeared on Quora – the place to gain and share knowledge, empowering people to learn from others and better understand the world.
